PM Modi’s move to replace R500 and R1,000 notes with new ones, while asking citizens to prove accountability for them—is only a partial demonetisation exercise. Legitimate holders of currency are after all getting their notes exchanged for new, equivalent, (albeit shockingly purple) ones! The standing assumption is that there is a ‘black sheep’ section of our society that has currency notes that they have obtained illegally, and therefore will be unable to exchange them at banks without the risk of getting caught. And then there are also those who are either intentionally or unwittingly, holding fake currency.
Currency in circulation is about 12% of the GDP. R500 and R1,000 notes are about 85% of the lot. So that comes to 10% of GDP. But not all of this 10% is headed for the incinerator. Only the ‘black’ ones are.
So by how much can we expect the cash in the economy to reduce? And what exactly happens to an economy when it decides to simply burn away some of the cash floating in the system? What does it mean for the RBI and its conduct of monetary policy?
The size of India’s black economy is estimated to be around 25% of the GDP. To put it in perspective; that is bigger than the combined share of agriculture and industry GDP! But how fast does this black money, exchange hands in this economy? That will help us determine how much black cash there is actually in the system.
Luckily there is a term for this, something that economists have been debating now for decades—called ‘velocity of money’. Broadly speaking, it stands for the amount of GDP that a single rupee is able to generate. For instance, suppose an IT professional spends R100 on fruits. The fruit seller now buys clothes using that money. And, then the cloth retailer feels the need to upgrade her IT system—so returns that R100 back to the IT professional. In the process, business worth R300 ends up getting generated by the same R100 note.
In mathematical terms, velocity of money is the ratio between GDP and money in circulation—which RBI estimates to be around 1.3 for India. However by ‘money’, it does not mean the cash that we exchange in day-to-day transactions (part of something called high powered money or M0). Instead it is broad money (also known as M3) where you also include bank deposits, post office savings and other bits and pieces of financial savings.
M3 and M0 in India are linked by a factor of 6—so roughly speaking, R1 of cash in circulation, ultimately adds up to R6 worth of broad money. So, if velocity of money calculated using broad money is 1.3, then it equates to six-times the amount, or 7.8 with respect to cash in circulation. So we now have a measure of how quickly transactional cash changes hands in the legitimate Indian economy.
Now, we do not really know the ‘rate of corruption’ in India—or how fast corrupt Indians churn cash. Probably a black money holder would be interested in moving cash into consumption quite quickly, in which case this numerical would be higher than 7.8. Or if black money holders are keener to stuff all their black cash under carpets and refrain from spending them too frequently, then it will be a smaller number.
For now let’s assume for a moment that cash travels as fast in the black money as it changes hands in the rest of the economy. So assuming velocity of black money at say 8, and with the black economy estimated at 25% of GDP—the amount of ‘black notes’ in the economy will be the nominal GDP divided by the ‘black’ velocity number—which equates to around 3% of GDP.
Of course not all these notes will be genuine. Fake currency is as much as 25% of the total currency in circulation. So take that out, and what remains are legitimate, but black money notes—worth 2% of GDP.
So let’s take it all in—the total R500 and R1,000 notes in the system before the purge, amounted to 10% of GDP. Of these, roughly 2% of GDP worth ‘black notes’ that will not find its way back to banks. This could of course be more or less depending on how you would like to play around with the basic assumptions. Nevertheless, that is at least a whopping 20% of the total cash in circulation.
This should be equivalent to a monetary tightening in the economy. In theory this should also lead to fall in inflation for a given velocity of money. Just as on the other far side of the spectrum, when a Venezuela or Zimbabwe keeps printing truckloads of money, it causes hyperinflation.
Let’s not forget; that with black money no longer available to flood inefficiently regulated sectors like jewellery, luxury goods, real estate, liquor, tobacco, etc—GDP is also expected to fall. After all on the night of PM Modi’s announcement, apart from ATM’s, the other commercial establishments that stayed open till late in the night were jewellery shops and luxury outlets. Gold price almost doubled in those few hours in some cities. Naturally, without the usual black money in the system, these sectors will now face a demand crunch, which in turn will cause fall in prices.
Velocity of money also changes in situations like these. On one hand the fall in economic activity in these sectors will negatively affect the frequency of cash transactions. However on the other hand, long queues outside banks for depositing cash are indicative of rapidly increasing bank deposits. Given the present state of the economy, this should translate into increase in bank lending, in turn increasing velocity of money.
So while money supply will be falling due to the evaporation of black cash, this will be countered by increasing velocity of money. So the price level in the economy may not fall as much as one would expect. Also, another subtle point is that these new bank deposits are by definition, increasing ‘broad’ money (or M3 as described earlier). So on one hand there is reduction of cash in circulation due to the black money witch hunt. But on the other hand, this will be partially offset by the increase in broad money due to the sucking up of the cash on the street into deposits in banks. So the fall in money supply may turn out to be limited.
There is, however, a longer term dynamic of monetary policy transmission that is worth considering. Today across the length and breadth of India, millions of people are making a beeline to banks. According to the World Bank, some 47% of India’s adult population remain untouched by any form of financial institutions. However over the past few days, this section of the society has been forced to find a bank to get their notes exchanged. Among the financial literate and upwardly mobile, the last few days has been marked by a massive migration to cashless transactions.
Harvard professor Kenneth Rogoff, in his recent book ‘The Curse of Cash’ has made a case for a completely cashless economy and how monetary policy will operate in that scenario. Maybe that is still some distance away for India, given that most of its consumption is still cash based. Maybe closer home, a working RBI paper on money velocity, back in 2011 is more relevant—which argues that while velocity of money for India has been persistently falling, financial deepening and inclusion can possibly help reverse the trend.
So as an economy, we may be at the verge of turning a corner here—a behavioural shift of citizens towards financial inclusion and cashless economy. And in the process, better monetary transmission. Whether it will indeed happen over the coming months and years will be a live test of theory.
The author is a senior economic adviser to a foreign mission,based in New Delhi. Views are personal